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The value of providing timely, relevant information to state and local governments and their stakeholders

Current
economic conditions, including job losses, illiquid credit markets,
an ailing construction industry and reduced consumer spending, have
combined to increase risk and uncertainty not only across all
private industries, but also in the public sector, including local
governments, states and, perhaps most importantly, the federal government.

AICPA
Statement of Position (SOP) 94-6, Disclosure of Certain
Significant Risks and Uncertainties, and FASB Accounting
Standards Codification (ASC) Topic 275, Risks and
Uncertainties, require certain disclosures about risks and
uncertainties relating to the nature of operations, the use and
significance of estimates in financial statements and the
vulnerability of financial statements to certain concentrations.

With
regard to concentrations, SOP 94-6 requires disclosure when
information known prior to issuance of the report has met these criteria:

The
concentration exists at the date of the financial
statements.

The
concentration makes the enterprise vulnerable to the risk of a
near-term severe impact.

It
is at least reasonably possible that events that could cause the
severe impact to occur will transpire in the near term.

Consider
a typical small business scenario with Company A, a manufacturer of
an electronic component for automotive air conditioners. Company A
has one primary customer that generates more than 60% of its annual
sales revenue. An auditor of Company A’s financial statements, based
on the guidance found in SOP 94-6, would conclude that all criteria
have been met to disclose a concentration risk: A concentration of
sales revenue exists; the concentration exposes the company to
near-term severe impact; and a downturn in automotive sales makes it
reasonably possible that such an impact would occur.

Now
consider a town with a highway fund that accounts for all road
maintenance activity for the town and related debt service. Eighty
percent of the town’s revenue for the fund comes from a share of
gasoline taxes that are distributed to it from the state. During
2009, in an attempt to balance its own budget, the state cuts the
distribution to the town by 90%. The town now faces the prospect of
either drastically cutting services to its residents or raising taxes.

In
contrast to the Company A example, no concentration disclosure will
be found in the town’s financial statements. And while a similar
scenario to the one described for the town has played out in
thousands of state and local governments over the past couple of
years, it is difficult in most cases to assess the extent of
intergovernmental financial dependency. This lack of transparency
occurs despite the fact that federal funds flowing to state and
local governments and state funds flowing to local governments
account for a substantial percentage of many of these governments’
budgets. The reason for this lack of disclosure may rest with the
belief that intergovernmental revenues are stable and that the risk
of events negatively impacting these revenues in the near term is
considered low.

That
theory no longer holds true. The 2008 economic crisis, subsequent
recession, 2011 debt ceiling debate and pending legislative actions
to further reduce federal deficit spending have taught us that the
fiscal sustainability of all three levels of government—federal,
state and local—is no longer a given if spending continues on its
current course. We all need to become better educated on the fiscal
strengths and weaknesses that contribute to the economic
sustainability of our governmental units.

With
access to relevant, timely and comparable information on
intergovernmental financial dependency, elected leaders of state and
local governments will be able to plan in advance for enacted and
anticipated shifts in federal funding; proactively address the
concerns of rating agencies over potential impacts on fiscal
capacity due to the risks of changes in direct and indirect
intergovernmental flows; communicate to residents and bondholders
with greater transparency; and contribute shared leadership to
effectively resolving the deficit spending and debt level problems
of the federal government.

As
financial professionals, it is incumbent upon us to see through the
sound bites and political posturing and gain an understanding of the
facts. And, as it turns out, there is plenty of reliable data out
there. Let’s start with the “800-pound gorilla” of the public
sector—the federal government.

UNDERSTANDING THE NUMBERS

Weighing
in at 233 pages, the 2010 Financial Report of the U.S. Government
(tinyurl.com/3f9flpl)
is not for the faint of heart. That said, as with the reports of
state and local governments, there is a Management’s Discussion and
Analysis (MD&A) section that covers all of the most essential
information on the financial condition of our federal government—and
it runs 26 pages. Given the enormous complexity of the federal
government and the diverse range of services it provides to
citizens, it is tough to determine a “corporate style” bottom line.
However, there is a “bottom
line” of sorts, and it is clearly spelled out in the 2010
Financial Report, which says, “The projections in this
Report indicate that the trajectory of current policy is not sustainable.”

Exhibit
1, extracted from the 2010 Financial Report, illustrates
the historical and current projections for federal spending and the
huge chasm that is growing between total receipts and total spending
because of the growth of noninterest spending and net interest. It
is important to note that, under current law, only “discretionary
spending” can be changed through normal budgetary mechanisms.
Discretionary spending includes defense and just about all other
federal spending that affects citizens in their daily lives,
including road construction, college grants and loans, health
research funds, K-12 education and homeland security.

The
remaining expenditures—including Medicare, Medicaid and Social
Security—are labeled “mandatory expenditures.” This spending, in
effect, is on autopilot unless benefits are fundamentally changed by
Congress and approved by the president. The congressional “super
committee,” formed as part of Washington’s deal on the debt limit in
August, was authorized, when it meets this fall, to begin to tackle
unsustainable spending in entitlement programs, as well as
reductions in discretionary spending.

THE FEDERAL DEBT BURDEN

With
the federal government spending more than its revenues in all but a
few of the past 40 years, it has built up a substantial debt. The
balance of publicly held debt as of Sept. 30, 2010, was $9.06
trillion, or 62% of annual U.S. gross domestic product (GDP).
Certain economists believe that, when viewed in relation to GDP, a
debt level of 62% is not that bad, since it’s below the approximate
109%-of-GDP level built up by the end of World War II. Before
breathing a sigh of relief, however, one must remember the alarming
trends illustrated by Exhibit 1.

The
MD&A section of the 2010 Financial Report states that
“(i)f current policies are kept in place indefinitely, the [publicly
held debt-to-GDP] ratio is projected to exceed 350% in 2085 and to
rise continuously thereafter.” The sobering reality is that,
depending on how all of the federal government’s liabilities and
other financial obligations are grouped, the United States has
already reached the 350%-of-GDP mark.

Exhibit
2 is an analysis based on data extracted from the 2010 Financial
Report. It illustrates what happens when you lump together all
of the federal government’s liabilities as they appear on its
balance sheet, including intragovernmental borrowing from the Social
Security and Medicare “trust funds,” and combine them with the
present value of all future benefit payments to those current and
future participants in Social Security and Medicare. As shown, these
liabilities and other financial obligations total $51.8 trillion,
which is 351% of 2010 GDP. In the end, or until these other promises
are altered by law, intragovernmental debt and social services
obligations will have to be addressed by the same productive
capacity of the nation, as will the repayment of publicly held
debt—which makes a case for why these other debts and obligations
also should be measured against the GDP yardstick.

TRICKLE-DOWN EFFECTS

Prior
to the mid-1960s, the three levels of government—federal, state and
local—generally tended their own gardens. The expansion of
intergovernmental funding since that time has, however, dramatically
altered that model. Using the published reports of state and local
governments, the data resources of the U.S. Census Bureau and Bureau
of Economic Analysis, and statistical reports of the U.S. Defense
Department, the General Services Administration and the U.S. Treasury Department, it
is possible to determine key measures of intergovernmental financial
dependency as shown in Exhibit 3.

Based
on a compilation from the 2009 audited financial reports of 47
states, the percentage of total state revenue that comes directly
from the federal government averages 39%. As illustrated in Exhibit
3, federal funds account for between 27% and 49% of the total
revenues of Virginia, Colorado, Pennsylvania and Illinois. The
economies of these four states also are affected by federal funds
flowing directly to their local governments, billions of dollars in
federal purchases from businesses located in the states, and
payments made by the federal government directly to their residents
for salaries and wages, pension benefits, Social Security and
Medicare coverage. Exhibit 3 illustrates how these total direct and
indirect federal flows range from 19% of real GDP for Colorado to
34% of real GDP for Virginia. Exhibit 4 also illustrates the
indirect economic impact of the federal government associated with
its ownership or lease of millions of square feet of buildings as
well as the presence of military facilities.

Similar
measures of intergovernmental financial dependency can be obtained
for local governments. For example, in Virginia, direct federal and
state assistance as a percentage of total locality revenues was 25%
for the cities of Virginia Beach and Richmond in 2008–09 and 32% for
Henrico County (see Exhibit 5). Indirect federal flows relating to
the purchases of goods and services and payments to individual
residents amount to hundreds of millions of additional dollars in
revenues for those localities.

Besides
the impact of federal funding and payments on state and local
governments, the businesses and residents of each state and a
variety of nonprofit organizations also are affected by these
federal flows. Clearly, we are all in the same boat, including the
members of the CPA profession who provide vital services to
businesses, governments, organizations and individuals throughout
each state.

ADDRESSING THE RISKS

Perhaps
the biggest risk from intergovernmental financial dependency is
ignoring its existence. Ignoring the federal government’s fiscal
problems has allowed the matter to get much worse, and to make the
options for resolution all the more painful. From the CPA’s
perspective, our challenge is that the clients we serve, most often,
do not recognize the buildup of risks within their financial
planning and reporting. Very few state and local governments
disclose and discuss the concentration of intergovernmental revenues
for their entire entity within their annual reports or seek to alert
their readers to the risks of such dependency. A continued absence
of dependency information will limit the ability of state and local
government leaders to take into account the ramifications of such
dependency when they seek to institute proactive measures prior to
reductions in intergovernmental flows and a possible worsening of
the federal debt crisis.

One
government that has taken a first step to boost its reporting on
intergovernmental dependency is the city of Durham, N.C. The
transmittal letter to its annual financial report contains this
warning about the risks associated with intergovernmental financial
dependency: “The City depends on financial resources flowing from,
or associated with, both the Federal Government and the State of
North Carolina. Because of this dependency, the City is subject to
changes in specific flows of intergovernmental revenues based on
modifications to Federal and State laws and Federal and State
appropriations. It is also subject to changes in investment earnings
and asset values associated with U.S. Treasury Securities because of
actions by foreign government and other holders of publicly held
U.S. Treasury Securities.”

This
disclosure, while generally worded supplemental information,
acknowledges the significant nature of intergovernmental financial
dependency and alerts the reader to the potential for changes caused
by outside forces.

An
additional example of how states might approach this issue can be
seen in the following illustrative note disclosure based on AICPA
SOP 94-6: “During fiscal year ending June 30, 2009, the State
received $25.8 billion from the federal government, which is 39.0%
of total State revenues reported by the primary government and
component units for charges for services, capital grants and
contributions, operating grants and contributions, and general
revenues. Funds flowing from the federal government to the State are
subject to changes to federal laws and appropriations. Based on the
reported financial position of the federal government, including
disclosures concerning fiscal sustainability, it is at least
reasonably possible that events will occur in the near term that
will significantly affect the flows of federal funds to the State.”

If
one ties this illustrative disclosure back to the reported
disclosures within the 2010 Financial Report, it becomes
inescapable that states, local governments and virtually all
elements of their respective economies are being, and will be,
affected by the unsustainable fiscal condition of the federal government.

THE CPA PROFESSION’S INVOLVEMENT

GASB
has a project on its agenda called Economic Condition Reporting:
Financial Projections (tinyurl.com/3fbjedq). The
project’s long-term objectives are to identify the information that
users require to assess a government’s fiscal sustainability, to
compare these needs with the information users receive under current
standards, and to consider whether guidance should be considered for
the remaining information. The project includes consideration of the
information necessary for users to assess the risks associated with
a government’s intergovernmental service interdependencies.

GASB
intends to publish a Preliminary Views document this fall that sets
forth the board’s thinking on how fiscal sustainability and
intergovernmental service dependency issues can be disclosed by
state and local governments, possibly as required supplemental information.

While
future guidance bearing on long-term fiscal sustainability evolves
through GASB’s due process efforts, CPAs preparing the financial
statements of state or local governments and CPAs performing attest
functions can respond today to the more present and immediate risks
associated with intergovernmental financial dependency. Such a
response can be developed by applying established GAAP and
professional judgment while considering information such as the
reported fiscal condition of governments providing intergovernmental
revenues and the degree to which the reporting government is
dependent on revenues, procurements or other flows received from
these intergovernmental sources.

In
this regard, state and local governments have several options for
reporting intergovernmental financial dependency, which, it is
important to note, do not contradict or conflict with GASB
pronouncements. In addition to the two disclosures mentioned above,
they could include the following information within their
comprehensive annual financial reports:

In
MD&A, a “description of currently known facts, decisions or
conditions that are expected to have a significant effect on
financial position or results of operations,” based on guidance
within GASB Statement no. 34, Basic Financial Statements—and
Management’s Discussion and Analysis—for State and Local
Governments (par. 11h), and GASB Statement no. 37,
Basic Financial Statements—and Management’s Discussion and
Analysis—for State and Local Governments: Omnibus (par.
4).

A
note to the financial statements providing “information about
the concentration of credit risk … by disclosing … investments
in any one issuer that represent 5% or more of total
investments,” including securities issued by the U.S. Treasury
Department, based on guidance within GASB Statement no. 40,
Deposit and Investment Risk Disclosures.

A
note to the financial statements citing “probable” future losses
in federal and/or state revenues based on enacted legislation
and/or “reasonably possible” future losses in revenues based on
the reported financial condition of a government providing
funding and known activities that are “more than remote” in
creating a reduction in intergovernmental revenues, based on
guidance within GASB Statement no. 62, Codification of
Accounting and Financial Reporting Guidance Contained in
Pre-November 30, 1989 FASB and AICPA Pronouncements.

Beyond
these specific measures, CPAs who prepare or audit governmental
financial reports should seek to understand the conditions reported
in the 2010 Financial Report of the United States Government
and the comprehensive annual financial reports of the state or
local governments in which they practice.

A SHARED CHALLENGE

The
CPA community is not alone in helping to bear the task of addressing
the federal government’s sustainability issues. Beyond ensuring that
their state and local government clients are aware of and are
properly acknowledging financial dependency on intergovernmental
flows, CPAs have an opportunity to develop an understanding of
recent recommendations for reforming federal fiscal practices and
the possible implications of recent changes to federal law
associated with raising the nation’s debt ceiling and curbing
deficit spending.

In
November and December 2010, three well-regarded, nonpartisan reports
were published that sought to identify reasonable ways in which the
federal government’s fiscal sustainability could be restored.
Notable among these reports were proposals from the National
Commission on Fiscal Responsibility and Reform, which issued its
formal report, The Moment of Truth (tinyurl.com/36o9okt), in early
December. The commission’s report tackles all of the major areas of
government policy that have the most significant impact on future
deficits, including discretionary spending cuts, tax reform, health
care, Social Security and process reform.

A
key point in the report is that all spending and revenue matters
must be taken into consideration together. Without doing so, the
political and other forces beholden to the status quo will inhibit
proceeding with the substantive changes necessary to alter the
fiscal trajectory of current policies. Although written in December
2010, well before this summer’s congressional debate, this point
still holds substantial merit.

In
the words of the report: “We must stabilize and then reduce the
national debt, or we could spend $1 trillion a year in interest
alone by 2020. There is no easy way out of our debt problem, so
everything must be on the table. A sensible, realistic plan requires
shared sacrifice—and Washington must lead the way and tighten its belt.”

EXECUTIVE SUMMARY

With major cutbacks in federal spending looming, more
attention needs to be paid to the financial interdependency of
federal, state and local governments and the impact of potential
federal cuts at the state and local levels.

The
percentage of total state revenue sourced directly from the
federal government averages 39%, based
on a compilation of the 2009 audited financial reports of 47
states. Local governments also are highly dependent on federal and
state assistance.

Very few state and local governments currently disclose and
discuss the
concentration of intergovernmental revenues for their entire
entity within their annual reports.

The
challenge of CPAs is to help government clients better
recognize the buildup of risk associated with intergovernmental
financial dependency within their financial planning and
reporting.

AICPA Statement of Position (SOP) 94-6, Disclosure
of Certain Significant Risks and Uncertainties,
can be a particularly valuable tool for assessing and disclosing
intergovernmental financial risks.

GASB intends to publish a Preliminary Views document in the fall of
this year that sets forth the board’s thinking on the disclosure
of long-term fiscal sustainability and intergovernmental service
interdependency issues by state and local
governments.

Elements of guidance within established GAAP can
be applied in developing potential disclosures relating to current
and historical intergovernmental financial dependency and related
risks.

Edward
Mazur (edward.mazur@cliftoncpa.com)
is a senior adviser for public-sector services with Clifton
Gunderson LLP; and John Montoro (jmontoro@cbh.com) is a
partner in the Richmond, Va., office of Cherry, Bekaert &
Holland LLP. Taylor Powell (taylor.powell@cliftoncpa.com),
an associate in the Federal Government Assurance practice of
Clifton Gunderson LLP, provided research assistance in the
preparation of this article. A version of this article
originally appeared in the March-April edition of Disclosures
magazine, published by the Virginia Society of
CPAs.

To
comment on this article or to suggest an idea for another
article, contact Kim Nilsen, executive editor, at knilsen@aicpa.org or
919-402-4048.

The
Governmental Audit Quality Center (GAQC) is a firm membership
center that helps member firms achieve the highest standards in
Yellow Book, not-for-profit, HUD or government audits through
targeted email alerts, resources and teleconferences. Visit the
GAQC at aicpa.org/GAQC.

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